Part I: Introduction

1. Part I: Introduction Chapter 1: Overview of Managerial Finance / Financial Management S.B.Khatri - AIM

2. 1.1 Financial Management: An Intro. The business function relating to the decisions involving: • What long-term investments should you take on ? What lines of businesses ? What sorts of buildings, machineries and equipments? (Investment Decisions) • Where will you get the long-term financing to pay for your investment? Will you bring in other owners or will you borrow the money? (Capital Structure Decisions) • How will you manage your everyday financial activities such as collecting from customers and paying suppliers? (Working Capital Management Decisions) • How the profit earned by the business shall be allocated to the owners? (Dividend Decisions) S.B.Khatri - AIM

3. Financial Management, broadly speaking is the study of ways to answer these three questions. • The maintenance and creation of economic value or wealth. • The study of investment decisions by corporations and ways the investment is financed • Finance uses accounting information together with other information to make decisions that affect the market value of the firm. • Conducting all financial matters of the organization in a way that ensures that funds are used in a proper and efficient manner S.B.Khatri - AIM

4. 1.2 Financial Management Decisions • Capital Budgeting/ Investment Decisions (Part IV) • Capital Structure Decisions/ Financing Decisions (Part V) • Working Capital Management Decisions (Part VI) • Dividend Decisions (Part V) Dividend Decisions are also sometimes considered as a part of Capital Structure Decisions. S.B.Khatri - AIM

5. 1. Capital Budgeting/ Investment Decisions • The process of planning and managing a firm’s long-term investments. • The types of investment opportunities that would typically be considered depend in part on the nature of the firm’s business. • Evaluating the size, timing, and risk of future cash flows is the essence of capital budgeting. • The financial manager tries to identify investment opportunities that are worth more to the firm than they cost to acquire. S.B.Khatri - AIM

6. 2. Capital Structure Decisions • A firm’s capital structure is the specific mixture of long-term debt and equity the firm uses to finance its operations and long-term investments. • Two concerns of financial manager: • How much of debt and how much of equity should the firm borrow? (the mixture chosen will affect both, the value and the risk of the firm)- optimum debt-equity ratio • What are the least expensive sources of funds for the firm? • How the firm as a pie is sliced among creditors and shareholders? • How and where to raise the money ? S.B.Khatri - AIM

7. 3. Working Capital Management Decisions • Working Capital refers to a firm’s short-term assets, such as inventory, and its short-term liabilities, such as money owed to suppliers (a/c receivables) • Day-to-day activity • Ensuring that firm has sufficient resources to continue its operations. • To avoid costly interruptions. • Relevant issues: • How much cash and inventory should we keep on hand? • Should we sell in credit ? What should be credit policy? • How shall we obtain needed short-term financing? S.B.Khatri - AIM

8. 4. Dividend Decisions • Related to the decisions regarding allocation of profit among the shareholders/owners. • What should be done with the profits of the firm ? • Whether dividend should be distributed or not ? • How much profit shall be kept in the form of retained earnings? • How much shall be ploughed back to the business? • Does the distribution of dividend increase the value of the firm ? S.B.Khatri - AIM

9. Some Fundamental Principles • Before we begin to study financial management in detail, there are two fundamental concepts that must be understood: • The right goal of the firm/financial mgt/manager • The risk/return tradeoff • These two concepts underlie every major technique that we will study S.B.Khatri - AIM

10. All management decisions should help to accomplish the goal of the firm! What should be the goal of the firm and hence the goal of FM ? S.B.Khatri - AIM

11. 1.3 Goal of Financial Management • Possible Goals • Survive • Avoid financial distress • Beat the competition • Maximize sales of market share • Minimize costs • Maintain steady earnings growth Controlling Risk Profitability S.B.Khatri - AIM

12. Problems with such goals • Maximize sales or market share • By lowering price or relaxing credit terms ? • Minimize cost • Doing away with things like R & D ? • Avoid distress and bankruptcy • By never borrowing any money or never taking risk ? • Survive • What about growth ? • Beat the competition • Placing dependence of your activities on competitor’s actions ? S.B.Khatri - AIM

13. Is it ? Profit Maximization? • Probably most commonly cited goal • But even this is not precise objective WHY ? S.B.Khatri - AIM

14. Issues regarding this goal What about risk from the perspective of shareholders • Do we mean profits this year ( current profit )? • If yes, then why not maximize profit by: • Deferring maintenance • Letting inventories run down • Canceling all casualty and liability insurance policies so that the money spent on premiums could go to profit instead. • Taking other short-run cost cutting measures • Shall we be overly concerned about short-term profits results rather than the long-term strategic positioning of the company ? • Ok fine ! Lets us refer to some sort of “long run” or “average” profits. • Does it give clear definition of what are we trying to maximize ? S.B.Khatri - AIM

15. Issues regarding this goal (contd…) • Do we mean something like accounting net income (NI) or earnings per share (EPS) ? • If yes, then these accounting numbers may be easily manipulated. • What do we mean by long run ? • This goal doesn’t tell us what the appropriate trade-off is between current and future profits. In the long run, we’re all DEAD ! S.B.Khatri - AIM

16. Incorrectness of this goal…. • This goal is inadequate for at least three reasons: • It ignores the time value of money • It ignores risk • It can lead to a preoccupation with short-term results which, in turn, can lead to sub-optimal long-term results We need goal that encompasses both factors: safety and profit S.B.Khatri - AIM

17. Correct Goal of the Firm/ FM Shareholder’s Wealth Maximization this is the same as: a) Maximizing Firm Value b) Maximizing Stock Price Eureka !!!!! S.B.Khatri - AIM

18. The Correct Goal of the Firm • The correct goal of the firm is to maximize shareholder wealth (i.e., shareholder’s equity) or, equivalently, to maximize the firm’s stock price. • By this we mean to imply that the managers of the firm work for the shareholders • For this reason, they have a duty to make investments that are expected to increase shareholder wealth • Further, they have a duty to take all investments that are expected to increase shareholder wealth S.B.Khatri - AIM

19. The Goal of U.S. West Inc. • From the U.S. West Annual Report to Shareowners 1988: Our mission is to provide quality products and services to customers in responsive and innovative ways in order to create the highest possible value for our investors through long-term growth and profitability S.B.Khatri - AIM

20. The goal of the firm should be to maximize the stock price! • This is equivalent to saying the goal is to maximize owners’ wealth. • Note that the stock price is affected by management’s decisions affecting bothrisk and profit. • Stock price can be maintained or increased only when stockholders perceive that they are receiving profits that fully compensate them for bearing the risk they perceive. S.B.Khatri - AIM

21. Shareholders’ Wealth Maximization • Good decisions increase the value of the stock, and poor decisions decrease the value of the stock. • Financial manager should act in the shareholder’s best interest by making decisions that increase the value of the stock. • The goal of FM is thus, to maximize the current value per share of the existing stock. • There is no ambiguity in the criterion, and there is no short-run vs long-run issue. • We explicitly mean that our goal is to maximize the current stock value (firm’s present value) S.B.Khatri - AIM

22. Does it seem little strong and one-dimensional ? • But, remember, shareholders are residual owners. • They get what’s left after employees, suppliers and creditors are paid their due. • If the stockholders are winning in the sense that the leftover, residual portion is growing, it must be true that everyone else is winning also. • How to identify those investments and financing arrangements that favorably impact the value of the stock ? That’s precisely what we will be studying in FM S.B.Khatri - AIM

23. Is stock price maximization the same as profit maximization? • No, despite a generally high correlation amongst stock price, EPS, and cash flow. • Current stock price relies upon current earnings, as well as future earnings and cash flow. • Some actions may cause an increase in earnings, yet cause the stock price to decrease (and vice versa). S.B.Khatri - AIM

24. The Goal of Financial Management • The primary financial goal is shareholder wealth maximization, which translates to maximizing stock price. • Do firms have any responsibilities to society at large? • Is stock price maximization good or bad for society? • Should firms behave ethically? S.B.Khatri - AIM

25. A more General Goal • What is the appropriate goal with firm without traded stock ? • It is difficult to say what the value per share is at any given time. • More generally it can be said that the goal is to maximize the market value of the existing owner’s equity. S.B.Khatri - AIM

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27. 1.4 The Risk/Return Tradeoff • Throughout financial theory, we assume that individuals are risk averse • This means that individuals prefer less risk to more risk • However, a risk averse individual will accept almost any level of risk as long as they are properly compensated • We assume that the risk-return tradeoff is a linear function (there is no good evidence that it isn’t) S.B.Khatri - AIM

28. The Risk/Return Tradeoff Graphically • Assume that there are two projects: A and B • Project B is riskier than project A • Therefore, we expect that B will, on average over time, earn a higher return than A • Otherwise, nobody would ever invest in B Return B A A B Risk S.B.Khatri - AIM

29. Risk-Return Tradeoff in Financial Decisions • Financial decisions often involve alternative courses of action. • Should the firm set up a plant which has a capacity of 1 Mln tons or 2 Mln tons ? • Should the debt-equity ratio of the firm be 2:1 or 1:1 ? • Should the firm pursue a generous credit policy or niggardly credit policy ? • Should the firm carry a large inventory or a small inventory ? • Each of alternative actions has different risk-return implications. S.B.Khatri - AIM

30. Risk-Return Tradeoff (contd….) • In general, making financial decisions involves answering following questions: • What is the expected return ? • What is the risk exposure ? • Given the risk-return characteristics of the decision, how would it influence value ? Capital Budgeting Decisions RETURN Capital Structure Decisions Market Value of the Firm Dividend Decisions RISK Working Capital Decisions S.B.Khatri - AIM

31. 1.5 Organization for the finance function • The responsibilities for financial management are dispersed throughout the organization. • The engineer, proposing a new plant, shapes the investment policy of the firm. • Marketing analyst provides inputs in the process for forecasting and planning. • Departmental managers, in general, are important links in the financial control system of the firm. • However, many of the specialized jobs of the FM are attended by specialist. • These tasks can be distributed between two key financial functions viz Treasurership and Controllership S.B.Khatri - AIM

32. Finance function in a Typical Business Organization S.B.Khatri - AIM

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34. Functions of the Treasurer and Controller S.B.Khatri - AIM

35. (2) (1) (4a) (4b) (3) (1) Cash raised from investors (2) Cash invested in firm (3) Cash generated by operations (4a) Cash reinvested (4b) Cash returned to investors Role of The Financial Manager Financial Firm's Financial manager operations markets S.B.Khatri - AIM

36. Other functions of financial officers • Involvement in injecting financial discipline in corporate management processes. • Monitoring the operations of the firm to achieve desired financial results. • Guide and participate in tasks of planning, funds allocation, and control so that the financial point of view is sufficiently emphasized in the process of corporate management. S.B.Khatri - AIM

37. 1.6 Agency Problem and the Control of the Corporation • Because managers work for the shareholders, they are considered to be agents for the shareholders. • Occasionally, managers may act in their own best interest, rather than in the interest of their shareholders • This is known as an agency problem S.B.Khatri - AIM

38. Agency Problem • Shareholders desire wealth maximization (at all cost?) • Do managers maximize shareholder wealth? • Mangers have many constituencies “stakeholders” • “Agency Problems” represent the conflict of interest between management and owners (within the agency relationship) S.B.Khatri - AIM

39. Agency relationships • An agency relationship exists whenever a principal hires an agent to act on their behalf and represent his/her interest. • Within a corporation, agency relationships exist between: • Shareholders and managers • Shareholders and creditors S.B.Khatri - AIM

40. Difference in Information Stock prices and returns Issues of shares and other securities Dividends Financing Different Objectives Managers vs. stockholders Top mgmt vs. operating mgmt Stockholders vs. banks and lenders Ownership vs. Management S.B.Khatri - AIM

41. Shareholders versus Managers • Managers are naturally inclined to act in their own best interests. • But the following factors affect managerial behavior: • Managerial compensation plans • Direct intervention by shareholders • The threat of firing • The threat of takeover S.B.Khatri - AIM

42. Shareholders versus Creditors • Shareholders (through managers) could take actions to maximize stock price that are detrimental to creditors. • In the long run, such actions will raise the cost of debt and ultimately lower stock price. S.B.Khatri - AIM

43. Managers and Shareholder Interests • Tools to Ensure Management Pays Attention to the Value of the Firm • Manger’s actions are subject to the scrutiny of the board of directors. • Shirkers are likely to find they are ousted by more energetic managers. • Financial incentives such as stock options S.B.Khatri - AIM

44. Solutions Agency Problem Solutions 1 - Compensation plans – tied to financial performance in general and oftentimes to share value in particular. 2 - Board of Directors- elected by shareholders, who, in trun hire and fire management. 3 - Takeovers 4 - Specialist Monitoring 5 - Auditors S.B.Khatri - AIM

45. Conflict between shareholders and Managers Ownersdelegateoperational control to agents. Agents, the managers, have their owngoals which may not be consistent with those of shareholders. Managers are monitored and selected by directors, who are elected by shareholders Shareholders attempt to control managers by Using incentives in employment contracts or pay with shares, stock options or profit sharing : Agency cost Agency costs are sum of • monitoring costs of the shareholders • costs of implementing the control devices Exploiting a competitive labor market Mounting a takeover offer and casting out the current managers S.B.Khatri - AIM

46. Agency Costs • There are two types of costs associated with the agency problem: • Direct agency costs are the loss in shareholder wealth due to managerial misconduct • Direct agency cost come in two forms: • Corporate expenditure that benefits management but costs the stockholders. Eg. Purchase of a luxurious and unneeded corporate jet. • An expense that arises from the need to monitor management actions. Eg. Paying external auditors. • Indirect agency costs are the costs of avoiding the agency problem S.B.Khatri - AIM

47. Whose Company Is It? ** Survey of 378 managers from 5 countries S.B.Khatri - AIM

48. Dividends vs. Jobs ** Survey of 399 managers from 5 countries. Which is more important...jobs or paying dividends? S.B.Khatri - AIM

49. Assets Debt Equity Control of Corporation elections Board of Directors selections Management Shareholders operations S.B.Khatri - AIM

50. 1.7 Relationship of Finance to Economics • Two important linkages: • Macro-economic environment defines the settings within which a firm operates • Micro-economic theory provides the conceptual underpinning for the tolls of financial decision making • Understanding of the macro-economic developments sensitizes the financial manager to the opportunities and threats in the environment. • Firm grounding in micro-economic principles sharpens his analysis of decision alternatives. • In fact, finance is applied micro-economics. S.B.Khatri - AIM